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Wednesday, December 30, 2015

Are You Experienced?

"Tell me, are you experienced? Well, uh, have you ever been experienced?" - Jimi Hendrix

The other day I ran across a series of articles by Boston Consulting Group (BCG), one of the prominent strategy consulting firms, revisiting their "classics".

One of these articles was The Experience Curve, a concept that has many uses in our work as strategy and finance practitioners.

Let's see how we can deploy this amazingly simple strategy concept.

The Basics

Figure A

Generic Experience Curve

As more units are produced, the cost per unit is less. The graph is on a log-log basis.

The experience curve theory resulted from industry studies performed by BCG and others. In essence, what they observed was that as experience was accumulated in production, the cost per unit went down in a fairly predictable fashion.

The basic curve is thus a plot of cost per unit on the y-axis and number of units produced on the x-axis, as shown generically in Figure A.

We can model the experience curve using the equation shown in Figure B. Essentially, the cost of the first unit is modified by the cumulative production (the n) by a factor (the exponent in the equation). Putting the reduction factor in the exponent allows us to

Figure B

Experience Curve Equation

model the costs by order of magnitude. The reduction factor reflects the lowering of costs for every doubling of volume. Since going from 2 to 4 is different than going from 4 to 8, or 32 to 64, placing this factor in the exponent creates the correct doubling factor.

Impact of Learning Example

BCG notes that it has been fairly well established that as people perform a task over and over there is a learning effect. This learning effect has been set at between 10% to 15% per doubling of production.

Figure C

Experience Curve Spreadsheet

From an intial hourly expenditure of 40, the time spent to perform each additional unit decreases. Arrows indicate doubled volume from previous arrow, and show a 10% reduction.

Figure C is an example of the Figure B equation in spreadsheet form. For this example we assumed a 10% reduction for doubled volume. The initial unit took 40 hours to perform. The 2nd unit was 36 hours (10% of 40 is 4, and 40-4 is 36). The arrows indicate further points where exact doubling has occurred.

The last column shows the cumulative hours spent. This is where we can see the ongoing impacts of the learning curve effect.

If we used our starting cost of 40 hours per unit, we would calculate that to make 6 units would take 240 hours. In the cumulative column, we see that after making the 7th unit, we had spent a total of slightly over 233 hours, so through the learning curve we were able to make 1 more unit than 'anticipated' using our initial hourly estimate.

This example helps explain some common corporate behaviors.

Often during goal setting, employees are told that they need to 'raise the bar' on their past performance. So long as they are performing the same task, the learning curve effect shows that this should in fact not be a problem.

Figure D

Annual Production

Annual production increases every year due to the learning curve effect, but increases are fewer and fewer. The rate of increase along arrow A's path is greater than arrow B's.

As part of the employee development process, organizations seek to provide opportunities to their promising 'high potential' candidates, which means assigning responsibilities to someone more junior than some of the more experienced employees. Figure D, which uses the data from Figure C carried out further into time, shows that as experience progresses the rate of improvement slows down. This makes sense, it takes less to go from 1 to 2 than from 2 to 4, and so on. Thus, the 'biggest bang for the buck' collectively might be to get those further to the left of the curve to move further to the right. In Figure D this is shown by the two lower arrows. The annual improvement when moving along the path of arrow A is greater than the improvement along arrow B.

If we imagine Figure D to be a company-wide phenomenon, we can also see how it becomes more difficult for them to grow as they age. If we've been in business for 100 years, it becomes awfully difficult to double the cumulative units to create a 10% reduction in time spent.

The Wealth of Nations (and Companies)

Adam Smith, in the economics classic The Wealth of Nations, discusses the benefit of Division of Labor. In the book he uses pin manufacturing as an example. We can use our experience curve equations to illustrate the division of labor benefit.

Let's suppose that 5000 years ago there were two societies, each composed of 3 people.

In this ancient time, they made only Food, Goods, and Raw Materials (which were consumed in the production of Food and Goods). In Society A, each member was self-sufficient, devoting part of their time to producing each of the 3 basic items.

In Society B, each member specialized in one of the items.

Each item takes 70 hours to produce the intial item, had a 10% learning curve effect, and there are 2000 working hours per year.

Figure E

Division of Labor

Society B, which divided their members into specialization, was able to produce 19% to 25% more items than Society A, which did not divide labor amongst its members.

Figure E compares the production output of the 2 societies. Society B, the one that divided their labor, produced a lot more than Society A (19%, 20%, and 25% respectively per year). This is due to the fact that each person, who is improving at 10%, is able to 'move up the curve' faster than their counterparts due to their specialization.

This example illustrates some of the underlying economics of strategy concepts like core competence. Firms that follow this paradigm often end up outsourcing activities that do not relate to their "critical" competencies - a form of specialization.

By focusing on activities that relate to our core competence, we are specializing in one specific thing, such as Worker A in Society B compared to Society A. This will allow us to do it at lower cost and effort than those who are doing a host of other things in addition to that activity.

Fortune Favors The Quick

The term "first mover advantage" is used in the strategy context to explain the benefit of a firm being first to market with a product or service.

Being first to enter can sometimes bring about domination of a niche due to the experience curve.

To illustrate, let's assume that Company A creates and develops a new market. It's intial cost of producing the first unit is 100, and it experiences a 20% experience curve effect (the 20% is the low end of BCG's assessment of the impact). During the first year it produces and sells 20 units.

Using this information in conjunction with the spreadsheet shown in Figure C, it's first year costs (the cumulative column in the spreadsheet) would be about 1,050. Let's further assume that starting up this operation requires a 10,000 investment which requires a 10% return, or 1,000 per year.

Based on this, the company will need to sell the 20 units at 102.5 each.

During their second year, still producing 20 units per year, they will incur costs of about 670 per year, which, after adding the 1,000 per year return requirement, means during year 2 they need to sell the 20 units at 83.5.

Figure F

First Mover Advantage

If Company B assumes it will enter and split the market, it's price will need to be 25% higher than Company A's in order to recoup its investment.

Figure F shows what occurs if Company B decides to enter the market in year 3, and the market will be split 50/50 upon their entry. Company B will need to charge 25% more per unit than Company A in order to earn the same returns. Given this situation, if the market remains at 20 units per year, Company A will sell all 20 of their units (since they are 25% less expensive), and Company B will sell none, rendering their 10,000 investment worthless!

This type of dynamic helps explain why the cluster of firms in Lititz Pennsylvania can maintain its dominance in the sound, stage and lighting services for major musical tours (WSJ article here).

What You Can Do

The experience curve phenomenon can be used in a number of ways:

Inventory Tasks Performed - by going through our firm's, department's, or individual job's roles, and classifying these by activity (or units of service or production) we can identify potential experience curve opportunities. These may be cultivated by reorganizaing work flows or selectively adding or eliminating certain steps in the process. The important thing here is to focus on the actual tasks. Many like to take shortcuts, such as classifying experience by department: "oh, they have three years in general accounting and two years in tax". While easy to do because it's easy to measure, it often does not help unearth the fundamental unit of service or production. For instance, if reconciling items from two different sources is a critical activity, someone with loads of experience in general accounting can make an immediate impact in tax if what they are doing in that area is reconciling accounts or calculations.

Use the Portfolio Effect - if we aggregate our firm's or department's experience curve, we can calculate how to best allocate experiential assignments versus their cost in order to remain on the 'efficient frontier' of our training and development program.

Have Faith - while evidence for the experience curve exists, it is difficult to see it tangibly in our day to day work lives - "Hey, that transaction took you 0.23 seconds less than yesterday!". Thus, while our Figure B equation is great and works in spreadsheets, it can be more difficult to implement when setting the budget for the year because manager's feel like they would be going out on a limb. It feels aggressive. Thus, to incorporate this into our planning process will feel like we are taking a leap of faith.

Use Our Synergies - when evaluating potential merger, acquisition, and divestiture scenarios, the experience curve can have a significant impact. The increased volume will accelerate the impact. For instance, if our firm started out doing 2 units per year the past two years (a total of 4), it would take us another two years to double the volume (4 + 2 + 2). If we combined with another entity that did the same volume (2 per year), we would achieve doubling in one year's time rather then two ( 4 + 4), reducing our costs more quickly.

Understand the "Other Side of the Coin" - actors / actresses in Hollywood who only get certain types of roles are considered 'typecast'. This can be a difficult situation for someone who is intent on learning, growing and discovering, since they never encounter anything new. Taken to the extreme, the experience curve would lead us to ever increasing specialization and narrowing of focus. While some might suggest the world is headed this way, we must also understand that assembly lines are not necessarily the best approach to an organization's structure and meeting its' peoples' needs. My kids love pizza, but they do not want it every night. We therefore need to maintain a balanced approach as we seek to leverage this opportunity.

Key Takeaways

The experience curve is a concise concept that explains a wide variety of critical business phenomemon, from competitive advantage to personnel management to strategic transactions. Because it takes work to analyze, many organizations do not take the time to do it, providing an opportunity to those that choose to do so.